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Fuentes ES 321 – Economic Evaluation of Industrial Projects
Problem Set 2
No. 1
A certain fluidized‐bed combustion vessel has an investment cost of $100,000, a life of 10 years
and negligible market (resale) value. Annual cost of materials, maintenance, and electric power for the
vessel are expected to total $8,000. A major relining of the combustion vessel will occur during the fifth
year at a cost of $20,000; during this year, the vessel will not be in service. If the interest is 15% per
year, what is the lump sum equivalent cost of this project at the present time?
Solution:
Let Investment Cost, C0 = $100,000
Life, L = 10 years
Annual cost of materials, etc AC = $8,000
Cost at year 5, C5 = $20,000
Interest rate, i = 0.15
AC
0 1 2 3 4 5 6 7 8 9 10
AC AC AC AC AC AC AC AC AC AC
C0
C5
Let EC = lump sum equivalent cost of the project
AC ⎡
1 − (1 + i ) ⎤ + ( C5 − AC )(1 + i )
−10 −5
EC = C0 +
i ⎣ ⎦
= $146,116.27
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No. 2
The heat loss through the exterior walls of a certain poultry processing plant is estimated to cost
the owner $3,000 next year. A salesman from Superfiber Insulation, has told you, the plant manager,
that he can reduce the heat loss by 80% with the installation of %15,000 worth of Superfiber now. If the
cost of heat loss rises by $200 per year (gradient) after the next year and the owner plans to keep the
building for 15 more years, what would you recommend if the interest rate is 12%?
Solution:
A. For Present worth of expenses (losses) without insulation:
Let First term of arithmetic gradient series A1 = $3000
Gradient G = $ 200
Interest rate i = 0.12
Number of periods n = 15
0 1 2 3 4 5 6 . . . . . 15
A1 A +G
1
A1+2G
A1+3G
A1+4G
A1+5G
A1+14G
G ⎡1 − (1 + i ) ⎤ A
−n
n
+ 1 ⎡1 − (1 + i ) ⎤
−n
PWE = ⎢ − n ⎥
i ⎢⎣ i (1 + i ) ⎥⎦ i ⎣ ⎦
= 27, 216.63
B. Present worth of savings, PWS:
Only 80% will be saved, so PWS = 0.8 ( 27, 216.67 )
= 21, 773.30
C. Recommendation: Since the present worth of all savings is greater than the investment on the
insulation, then Install the Superfiber.
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No. 3
You are the manager of a large oil refinery. As part if the refining process, a certain heat
exchanger (operated at high temperatures and with abrasive materials flowing through it) must be
replaced every year. The replacement and downtime costing the first year is $175,000. Therefore, it is
expected to increase due to inflation at a rate of 8% per year for five years, at which time this particular
heat exchanger will no longer be needed. If the company’s cost of capital is 18% per year, how much
could you afford to spend for a higher‐quality heat exchanger so that this annual replacement and
downtime cost can be eliminated?
Solution:
Let First term in the geometric gradient series A1 = $175,000
Inflation rate f = 0.08
Interest rate i = 0.18
i − f 0.18 − 0.08
Convenience rate (for f ≠ i) icr = =
1+ f 1 + 0.08
= 0.09259
0 1 2 3 4 5
A1
A1(1+f)
A1(1+f)2
A1(1+f)3
A1(1+f)4
The Present Worth of all Costs:
A ⎡1 − (1 + icr )− n ⎤
PW = 1 ⎢ ⎥
1+ f ⎣⎢ icr ⎦⎥
175, 000 ⎡1 − (1.09259 ) ⎤
−5
= ⎢ ⎥
1.08 ⎣⎢ 0.09259 ⎦⎥
= $626, 050.52
Recommendation : The company could afford a high‐quality heat exchanger worth up to $ 626,050.53
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No. 4
A small company purchased now for $23,000 will lose $1,200 each year for the first four years. An
additional $8,000 invested in the company during the fourth year will result in a profit of $5,500 each
year from the fifth through the fifteenth year. After 15 years the company can be sold for $33,000.
a) Determine the IRR and
b) Calculate the FW if MARR = 12%.
Solution:
Cash Flow Diagram: let i = interest rate = internal rate of return (IRR)
SV
B B B B B B B B B B B
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
A A A A
C0
C4
Where: C0 = $23,000
A = $1,200
B = $5,500
C4 = $8,000
SV = $33,000
Equation of values: using a focal date at (4)
A⎡ B
0 = −C0 (1 + i ) − (1 + i ) − 1⎤⎦ + ⎡⎣1 − (1 + i ) ⎤⎦ + SV (1 + i ) − C4
4 4 −11 −11
i ⎣ i
In solving for i = IRR, we get
IRR = 0.10011112 or 10.011%
b) for the future worth at (15) using i = 0.12:
A⎡ B
FW = −C0 (1 + i ) − (1 + i ) − 1⎤ (1 + i ) + ⎡(1 + i ) − 1⎤ + SV − C4 (1 + i )
15 4 11 11 11
i ⎣ ⎦ i ⎣ ⎦
= $27, 070.36
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No. 5
A food processing plant consumed 600,000 kwh of electric energy annually and pays an average
of P2.00 per kwh. A study is being made to generate its own power to supply the plant energy required,
and that the power plant installed would cost P2,000,000; annual operation and maintenance,
P800,000; Other expenses, P100,000 per year. Life of the plant is 15 years; salvage value at the end of
life is P200,000; annual taxes and insurance, 6% of the first cost; and rate of interest is 15%. Using the
sinking fund method for depreciation, determine if the power plant is justifiable.
Solution: By the Annual Worth Pattern (AWP)
a) Annual Revenue (savings) = (P2/kwh)(600,000 kwh) = P 1,200,000
b) Annual Expenses = depreciation + annual operation, etc + other expenses + interest on money
[ 2, 000, 000 − 200, 000] 0.15 + 800, 000 + 100, 000 + 0.06 2, 000, 000 + 0.15 2, 000, 000
AE = ( ) ( )
(1.15) − 1
15
= P 1,357,830.70
c) Since the annual expenses are greater than the annual savings, the purchase of the power plant
is NOT JUSTIFIED.
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No. 6
The Anirup Food Processing Company is presently using an outdated method of filling 25‐pound
sacks of dry dog food. To compensate for weighing inaccuracies inherent to this packaging method, the
process engineer at the plant has estimated that each sack is overfilled by 1/9 pound on the average. A
better method of packaging is now available that would eliminate overfilling (and underfilling). The
production quota for the plant is 300,000 sacks per year for the next six years and a pound of dog food
costs this plant $0.15 to produce. The present system has no salvage value and will last another four
years, and the new method has an estimated life of four years with a salvage value equal to 10% of its
investment, I. The present packaging operation expense is $1,200 per year more to maintain than the
new method. If the MARR is 12% per year for this company, what amount, I, could be justified for the
purchase of the new packaging method?
Solution: By the Annual Worth Pattern
Let I = justified investment
1
a) Annual Savings = ( 300, 000 )( 0.15 ) + 1200
9
= 6200
b) Annual Expenses = capital recovery cost
=
[ I − 0.1I ] 0.12 + 0.12 I
(1.12 ) − 1
4
= 0.308311I
c) Equating the savings to the expenses:
6200 = 0.308311I
I = $20,109.56
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No. 7
A manufacturing firm has considerable excess capacity in its plant and seeking ways to utilize it.
The firm has been invited to submit a bid to become a subcontractor on a product that is not
competitive with the one it produces but that, with the addition of $75,000 in new equipment, could
readily be produced in its plant. The contract would be for five years at an annual output of 20,000
units.
In analyzing probable costs, direct labor is estimated at $1.00 per unit and new materials at
$0.75 per unit. In addition, it is discovered that in each new unit, one pound of scrap material can be
used from the present operation, which is now selling for $0.30 per pound of the scrap. The firm has
been charging overhead at 150% of prime cost, but it is believed that for this new operation the
incremental overhead, above maintenance, taxes, and insurance on the new equipment, would not cost
60% of the direct labor cost. The firm estimates that the maintenance expenses on this equipment
would not exceed $2,000 per year, and annual taxes and insurance would average 5% of the investment
cost. (Note: Prime cost = direct labor + direct materials cost).
While the firm can see no clear use for the equipment beyond the five years of the proposed
contract, the owner believes it could be sold for $3,000 at that time. He estimates that the project will
require $15,000 in working capital (which would be fully recovered at the end of the fifth year), and he
wants to earn at least a 20% before‐tax annual rate of return on all capital utilized.
a. What unit price should be bid?
b. Suppose that the purchaser of the product wants to sell it at a price that will result in a
profit of 20% of the selling price. What should be the selling price?
Solution:
Let CU = unit bid price of the product
PART A:
a) Annual revenue = 20,000(CU)
b) Annual expenses = depreciation + labor cost + maintenance + taxes & insurance
+ material cost (new and scrap) + overhead
+ recovery cost of working capital+ interest on money
depreciation =
[ 75, 000 − 3, 000] 0.20 = 9, 675.34
(1.20 ) − 1
5
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No. 8
The prospective operation for oil in the outer continental shelf by a small, independent drilling
company has produced a rather curious patter of cash flows as follows:
End of Year Net Cash Flow
0 − $ 520,000
1 – 10 + 200,000
10 − 1,500,000
The $1,500,000 expense at the end of the tenth year will be incurred by the company in
dismantling the drilling rig.
a) Over the 10‐year period, plot PW versus the interest rate (i) in an attempt to discover
whether multiple rate of return exist.
b) Based on the projected net cash flows and results in part (a), what would you recommend
regarding the pursuit of the project? Customarily, the company expects to earn at least 20%
per year on invested capital before taxes. Use the ERR method.
Solution:
A A A A A A A A A A
Cash Flow Diagram:
0 1 2 3 4 5 6 7 8 9 10
C0
C10
a. Equation to solve for the present worth with interest i:
A⎡
1 − (1 + i ) ⎤ − C10 (1 + i )
−10 −10
PW = −C0 +
i ⎣ ⎦
200, 000 ⎡
1 − (1 + i ) ⎤ − 1,500, 000 (1 + i )
−10 −10
PW = −520, 000 +
i ⎣ ⎦
Note: See separate paper for chart (graph) of PW vs. i .
At PW = 0, i = 0.2877632
b. Solving for ERR (i’), using ∈ = 0.20
200, 000 ⎡
520, 000 (1 + i ' ) + 1,500, 000 = (1.2 ) − 1⎤⎦
10 10
0.2 ⎣
i = 0.21653 or 21.653% > 20%
Recommendation: Project is justifiable.
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No. 9
Alpha Company is planning to invest in a machine the use of which will result in the following:
− Annual revenues of $10,000 in the first year and increases of $5,000 each year, up to year 9.
From year 10, the revenues will remain constant ($52,000) for an indefinite period.
− The machine is to be overhauled every 10 years. The expense for each overhaul is $40,000.
If Alpha Company expects a present worth of at least $100,000 at a MARR of 10% for this project, what
is the maximum investment that Alpha should be prepared to make?
Solution:
Let PR = Present Worth of all revenues
10, 000 ⎡ 5, 000 ⎡1 − (1.10 )−9 9 ⎤ 52, 000
1 − (1.10 ) ⎤ + (1.10 )
−9 −9
PR = ⎢ − ⎥ +
0.1 ⎣ ⎦ 0.1 ⎢⎣ 0.1 (1.10 ) ⎥⎦ 0.1
9
= $375, 228.26
Let PE = Present Worth of all expenses
I = investment
40, 000
PE = I +
(1.10 ) −1
10
= I + 25098.16
Since the net present worth should at least be P 100,000
PR − PE ≥ 100, 000
375228.26 − ( I + 25098.16 ) ≥ 100, 000
I ≤ $250,130.10
Maximum investment should only be $250,130.10.
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